Venture capital firms are fierce supporters of the digital revolution, yet while doing so they also put their own business at risk of disruption. Are they bolstering digitalisation unwittingly?
Since the dawn of barter, financial markets have morphed according to prevailing business ecosystems. Today’s setup was created by the 16th-century Dutch merchants who built the first stock exchanges and by the French and Britons who created the first investment funds during early industrialisation.
Not much has changed since then, except that clock speed has been upped from Rothschild’s pigeons to optical fiber at the top high-frequency trading houses.
Now, digitalisation, and the collaborative economy that comes with it, will bring yet another seismic shift that will revamp the entire financial services industry as we know it.
A lot is at stake. The junk bond market alone, designed to support struggling businesses, was worth 2 trillion dollars last year. In contrast, investments into the venture capital industry, designed to create innovation, was 50 billion dollars. Forty times more money is sloshing around supporting the struggling dinosaurs than in creating the new. A transition from old to new order would unlock a flood tide and change today’s financial markets for good.
In the classic financial market increasingly dominated by machine learning and resulting closet indexing, the most relevant valuation variable becomes innovation. Rest can be automated. And the establishment is starting to acknowledge this. At this year’s LendIt conference, former treasury head Larry Summers thundered that financial regulators cannot continue to excessively burden those who innovate.
That said, venture capital, the culprit of this change, won’t be unaffected either as the collaborative economy, in the form of crowdfunding, will eat into their proprietary deal flow. What’s more, the prevailing low-interest rate environment has forced new entrants, such as hedge funds and family offices, to seek investment opportunities outside the stock exchange, increasing late-stage competition even further. Venture capital firms are getting squeezed by crowdfunding platforms from below and by hedge and private equity funds at the top.
This all may have been anticipated. But what if the flow towards early stage is persistent enough so as to eventually create a new investment grade asset class? This would change the game entirely as the pool of tradeable securities would expand significantly. Investors would invest in early stage startups for growth and in traditional stock listed shares for dividends.
While die-hard investment bankers would be the biggest losers in this transition, regular people and venture capitalists would emerge as the winners. Crowdfunding would control the earliest stage and venture capitalists would hold middle ground, investing more safely in a much larger pool where the product/market fit has been better validated.
But what can we expect of the “much larger pool?” The World Bank expects that the global crowdfunding market will quickly surpass the size of today’s venture capital market and grow double as big in the next ten years as what venture capital is today. Old constituents, from Bloomberg to BBVA, have set up vehicles to control the threat from technology startups. Even Jamie Dimon agrees. But how exactly this disruption will affect venture capital and its returns is still under debate.
We expect the venture capital industry to transform in four steps:
Step 1. Early stage will become legit. Validated deal flow through crowdfunding functions will mitigate some of the risks associated with early-stage investing through a more effective product/market mix process.
Step 2. More risk-averse investors will move towards earlier-stage investing to better balance investments between dividend-yield and growth.
Step 3. Fund size will grow and new players will enter. The leading players will grow even bigger as investor appetite for innovation and growth expands.
Step 4. Fund variety will increase. While some players will become specialized in a vertical or stage while sticking to their limited partners, others will become more generalist, offer a mix of funds and attract more direct private investments.
Managing this transition is especially important for the Nordic region, which has spawned every tenth billion-dollar startup in the world and which strapped economies, with dying commodities industries, are increasingly dependent on innovation.
But the region, which is punching way above it’s weight in creating startups, has a relatively underdeveloped venture capital industry. Especially so in Finland, where startup financing has been incubated by government-led funding incentives. Sweden and Norway have found a mutually beneficial relationship based on more mature venture capital, while Denmark is carving a special relationship towards the rest of Europe.
That said, Finland, being probably the least developed venture capital market in the Nordics, may also carry the least inertia for change. As a precursor, Inventure was the first Nordic venture capital firm to invest in a crowdfunded startup and has since slowly built a special relationship with FundedByMe, the region’s leading crowdfunding platform, and other collaborative communities such as Slush, the largest startup conference in Northern Europe.
Sweden and Norway, with Northzone and Creandum, have in turn taken steps towards the upper end of the spectrum by investing follow-on rounds in later-stage startups, such as Spotify, which require more investment clout. Both were early investors in the music streaming startup.
Denmark’s Sunstone, the youngest of the top funds, is increasingly focusing on the earlier stage by leading rounds into IE Business School incubated Tyba in Madrid and Finland’s Everywear Games, the first gaming startup focusing on Apple Watch. But none of the top players, bar Inventure, have openly leveraged their deal flow on the peer-to-peer economy just yet.
While all Nordic venture capital houses are still industry agnostic, the four most active funds mentioned here are increasingly moving towards investing in digital disruption and some are showing signs of expanding too fast for seed level investing, indicating a preference for later stage rounds. Given the historic strengths in the region, it would fall naturally for Swedish funds to focus on consumer and e-commerce products, while those in Finland would find a niche within gaming and the Internet of Things.
The reshuffle has already started and the diversity is increasing, but it still remains unclear who will leverage on disruption at which stage, and how big these funds will grow with the shift from old to new. But the floodgates are now opening for a very different venture capital industry.
In the next decade, you may be able to invest with digital currency directly into a venture capital sub-fund that focuses on investments in early-stage artificial intelligence and robotics using pre-screened product/market fit processes. Or an exchange-traded fund-of-funds for pre-IPO automotive technology disruption.
One thing is for sure, venture capital won’t be the same. And neither will today’s investment strategies.
Venture capital is dead, long live venture capital!